Y2K litigation impact on insurance stocks

LOS ANGELES (CBS.MW) -- Even before the millennium arrives, insurance firms are facing Y2K litigation as companies seek to recover the costs of preparing their computers for the event -- and it could cost insurers billions.

"As an insurance lawyer,
I would say this is a viable theory and there's a legitimate argument to be made here by
the businesses to get their money back."
David Schack, Mitchell Silberberg &amp; Knupp

The Department of Commerce estimates that cumulative spending by the government, corporations and consumers to fix Y2K problems has surpassed $100 billion, or $365 per U.S. resident, since 1995. The majority of that spending -- about $30 billion a year -- occurred in 1998 and 1999, the group says.

While the amount at stake for the insurance companies is less than what's been spent for Y2K compliance, settlements could range into the billions, according to David Schack, a lawyer who litigates insurance claims for businesses at the Mitchell Silberberg & Knupp law firm in Los Angeles. He compared the risk to a large-scale disaster.

"When you have a hurricane or something else, the insurance companies pay out hundreds of millions or even billions of dollars and then they have to deal with those losses in terms of their underwriting and their premiums in future years," said Schack.

Legal architecture

The legal theory at issue, called "sue and labor," is one that dates back several hundred years when insurance companies encouraged sailors to throw cargo overboard or take action to reduce or prevent the loss of a sinking ship, said Schack. See related story.

Whether companies like GTE
GTE, -0.76%
Xerox
XRX, -2.09%
and Nike
NKE, -0.65%
that are heading to court to recover Y2K compliance costs can use the sue and labor argument is debatable, he said.

"As an insurance lawyer, I would say this is a viable theory and there's a legitimate argument to be made here by the businesses to get their money back," said Schack, noting that he expects courts to begin ruling whether these expenses are covered within the next year.

But an insurance industry trade group maintains that pre-Y2K fixing costs fall under the category of ordinary business expenses. "The Y2K situation in general is not an insurance issue," said Bob Hartwig, chief economist at the Insurance Information Institute in New York. "They're trying to get insurers to pay for expenses they would have incurred anyway."

"The reason they did this is to avoid a loss of confidence on Wall Street and to avoid a loss of confidence among their consumers," said Hartwig, adding that companies have suffered no damages. He called the use of the sue and labor clause "entirely inappropriate in this context."

Investors take heed

Schack advised investors to pay attention. "While the investing public might be aware there's a potential for these insurance companies to suffer some sort of losses if there are Y2K problems, I don't think it's a well-known issue that they may face these problems even if everything goes fine on the date change."

GTE, for one, is not wasting any time. The Irving, Texas-based telecommunications firm is suing five companies including Allendale Mutual Insurance, Allianz, Federal, Affiliated FM, and Industrial Risk Insurance for an amount not to exceed $400 million, according to Bobbi Hennessey, a GTE spokesperson.

Although GTE began its Y2K remediation work in 1995, it waited until June to file papers because the costs of the program were still unknown. By the end of the first quarter of 1999, GTE had spent $287 million on their remediation program.

Hennessey said the company's work has not included ordinary maintenance or upgrades. "This is not for system replacement," she said. "It's strictly for the cost to protect our data from problems related to the Y2K date- and time-recognition issue."

The company's insurance required that the work be done in order to meet the terms of continued coverage, she said. "We were asked to sign exclusions for Y2K remediation costs which would have retroactively given up our right to recovery, but we did not sign any of those exclusions," said Hennessey. "So you have to wonder if the claims are not covered why we're being asked to sign away our right to recover."

Hennessey said GTE is confident it will win. "We feel like we've met our obligation under our policies and we'd like the insurance companies to meet theirs."

An analyst's advice

"My sense is that it
will be an annoyance to the industry, but it certainly won't threaten the solvency of the
industry at all."
Jay Cohen, Merrill Lynch

The insurance industry may be targeted, but that doesn't necessarily mean it will get hit, according to Jay Cohen, insurance analyst at Merrill Lynch in New York. "In our view, the insurance industry has very good defenses that indeed they will not have to pay claims for the actual remediation expenses."

Cohen backed up the insurance industry's stance that the actions taken were not "imminent," and perhaps not limited to Y2K fixes but also directed at upgrading and ordinary maintenance.

After 2000 arrives, Cohen said, he expects different policies like liability, property, business interruption, directors' and officers' liability and even workers' compensation will have to cover insured events related to Y2K problems. He added that it's difficult to gauge what those claims may cost the industry.

"In some cases they will have to pay claims and in other cases they won't," Cohen said, noting that legal expenses for remediation, by contrast, are a sure thing. "Even if the industry ends up paying no claims at all, they will be forced to defend themselves when claims are filed."

Overall, the industry should remain well-capitalized, he said. "My sense is that it will be an annoyance to the industry, but it certainly won't threaten the solvency of the industry at all," said Cohen.

"If you had to build this into an investment thesis, you might say stick with companies with real solid balance sheets that could withstand a shock loss like this."

Cohen named AIG
AIG, +0.23%
St. Paul
SPC, +0.00%
Hartford Financial Services
HIG, +0.24%
and Travelers Property Casualty
TAP, -1.25%
as examples. Cohen has a "buy" rating on Travelers and an "accumulate" rating on the other three have insurers.

One of the defendants in the GTE case, Federal Insurance, is a subsidiary of Chubb [cb]. "Chubb has a very good balance sheet," said Cohen. "We are not recommending Chubb right now, not because of that issue but other issues. I couldn't yet counsel to stay away from the stock (due to) the GTE situation."

Another company Cohen identified as having a solid balance sheet is XL Capital
XL, +0.70%
which Merrill has listed as a "buy."

"We've been conservative on the group anyway because the fundamentals have been a challenge," he said. "The fact that we're conservative should protect us to some extent."

In a best-case scenario for investors, the industry wouldn't have to pay remediation costs, in which case it's a "non-event," said Cohen. But if insurers do have to pay, the ride would be rough in the near term, but with a longer-term upside.

"The bad news is these companies (would) lose a lot of money," said Cohen. "The good news is it would further the shake-out in the industry and it would likely cause prices to rise for most lines of insurance."

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